The Hidden Dangers of Investing in a Low-Interest Rate Environment by Todd Moll, CFP, CFA
For the first time in seven years, the Federal Reserve lifted its pledge of “patience” in raising interest rates. While maintaining a cautious outlook for the future, the Fed’s March 2015 announcement is good news for borrowers looking to take advantage of historically low rates. For investors chasing high-yields, however, the news may not be so positive. In fact, due to a prolonged period of low interest rates, many investors who fled the “safety” of conservative fixed-income vehicles, such as bonds, may be surprised to find that their moves into other products, including other bonds, annuities and dividend-paying stocks, may be less risky than they originally thought.
The traditional approach to investing as one aged relied on increasing the use of bonds to provide liquidity, preservation from market swings and a more reliable future income. While the Fed’s program of low interest rates and quantitative easing has indeed helped to turn around the economy, these actions, combined with longer life spans, have put a considerable dent in retirees’ savings. As a result, many retirees were faced with the prospect of outliving their savings and the inability to cover the rising costs of health care later in life. Investors sold bonds for less than they paid and moved into new vehicles in search of higher yields. However, these moves bring with them risks that many retirees may not be prepared to face, especially with the prospect of rising interest rates.
Interest Rate Risk. Changes in interest rates have the potential to negatively affect the value of an investment. Generally, as interest rates rise, bond values fall, often leading to a loss of investment principle. While the Fed may raise interest rates 1 percent, the price of bonds could decline more than 6 percent, depending on its maturity date and a variety of other factors. As a result, investors who anchored the bulk of their portfolios with the “safety” of bonds could face a heightened risk of declines in their portfolio values, especially if they sell those investments before their maturity dates. Conversely, investors who hold their bonds to maturity limit their exposure to interest rate risk.
Duration Risk. Duration is the number of years required before an investor can recover the true cost of an investment. By taking into consideration a number of factors, including present value and future interest payments, duration helps to measure an investment’s sensitivity to interest rates. Typically, the longer an investor holds an investment, the more the price will fluctuate with changes in rates. When investors sell bonds before their maturity dates, they are more exposed to price volatility and less likely to receive the face value, especially in a rising interest rate environment.
Credit Risk. Bonds come with the risk of credit quality being downgraded by rating agencies, including Moody’s, Fitch and Standard & Poor. Similarly, stocks and bonds carry the risk that the issuer will go out of business or default and fail to make principal payments. Generally, the lower the rating and higher the yield, the higher the credit risk.
Liquidity Risk. With the possibility of an interest rate hike, there is a concern that too many investors will attempt to sell investments at the same time or that there will not be a market of buyers to whom investors may sell the securities at a reasonable price. For example, consider auction rate securities that were aggressively marketed as high-return cash-equivalent investments in the late 1990s and early 21st century. However, in 2008, at the height of the financial crisis, liquidity dried up and market makers turned their backs on investors who sought to sell the securities back to investment banks. Thanks to class action lawsuits, some investors were fortunate to sell their holdings back to the banks at par, while others continue to have challenges liquidating the investments to this day.
Similarly troubling for investors is the lack of market makers in the high-yield, fixed income market. When interest rates rise, there may not be anyone willing to buy bond investments when investors seek to sell.
Other Risks. Depending on an individual’s investment horizon, seemingly conservative investments, such as low-volatility and dividend-paying stocks, may not provide the stability retirees and near-retirees need to maintain a steady income during their golden years. While the U.S. equity markets have been up for five years, a series of factors, both stateside and internationally, can cause a steep drop that can eat into one’s principal savings. Along the same lines, individuals who hold large amounts of their life savings in cash incur equally significant opportunity costs. To be sure, holding a certain amount of cash is an important part of any investor’s portfolio. It provides provide flexibility, liquidity and a buffer against lean times. However, too much cash-on-hand means that hard-earned money does not have an opportunity to grow.
There is no one magic solution to mitigate one’s investment risks, especially in an evolving market. Investors must assess their risk tolerance, gain a clear understanding of the risks associated with a particular investment and accept the fact that there are no absolutes in investing. A strategy that yields high returns today may not bear the same results in the future. Similarly, no investment is without risk. Investors must take a leap of faith and accept some level of risk if they expect to grow their wealth. However, risk tolerance and the ability to absorb risk will vary widely from one individual to another, depending on each’s unique circumstances. By taking their strategies off autopilot and conducting regular reviews of their existing investment portfolios, investors may remain diversified through changing market cycles and match the appropriate investment with their specific goals and tolerance for risk.
About the author: Todd A. Moll, CFP®, CFA, is a director and chief investment officer with Provenance Wealth Advisor, an independent financial services firm affiliated with Berkowitz Pollack Brant Advisors and Accountants. He can be reached at (954) 712-8888 or via email at email@example.com.
Provenance Wealth Advisors, 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.
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This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. Dividends are not guaranteed and must be authorized by the company’s board of directors. Past performance may not be indicative of future results. Investing involves risk and you may incur a profit or loss regardless of strategy selected.